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Alternatives: Income hungry investors should look at ground rents

For investors looking to diversify their portfolios away from equities and bonds, property is often a popular choice. However, as the low interest rate environment enters its sixth year, demand for yielding property investments has pushed up valuations and compressed yields. Prudent investors may want to consider diversifying their exposure away from commercial or residential property and into other, lesser-known areas, such as ground rents.

Ground rents are payments awarded to the freeholder of a property that has been sold on a leasehold basis, which are not to be confused with service charge payments that are used to maintain the property. For the leaseholder, these payments are a fraction of their lease value (typically 1/1,000th) but failure to pay results in the leaseholder losing their property to freeholder. Consequently, default rates have historically been very low.

Ground rents are an unusual breed of financial instrument as their value is far lower than the asset serving as collateral, thus creating a rare occasion where a default event is potentially the best-case scenario for the freeholder. For a leaseholder faced with the option of paying, for example, an annual ground rent of £200 or losing their property worth perhaps £200,000 the choice is simple and this is why the payments tend to be so reliable.

For many freeholders, administering the collection of these ’token’ payments is regarded as an inconvenience or a non-core business activity, so they choose to sell their ground rent claim. Institutional and other investors have been accumulating portfolios of ground rents for many years and specialise in the administrative process of rent collection that has served to deter many investors from participating.

Funds such as The Ground Rents Income Fund and the Freehold Income Trust were created to provide access to a broad range of investors, including retail, that want exposure to the asset class. These funds have appointed specialist property management companies that are responsible for sourcing ground rent assets and then collecting the payments from leaseholders as they are due. The Ground Rents Income Fund is structured as a closed-ended property fund with a fixed pot of capital to invest, so there is no requirement to satisfy redemption and subscription orders from clients, which feels appropriate for an underlying asset that doesn’t trade with the regularity of stocks and bonds.

The payment value of a ground rent is set at the point of leasehold sale and includes terms for periodic increases, such as doubling every 10 years or increasing every five years in line with RPI. In an environment of record low interest rates, the demand for alternative sources of defensive, inflation-protected cash flows has soared. Ground rents have been a beneficiary of this and over recent years investor demand has driven up prices so capital appreciation has far exceeded the actual ground rent payment.

According to the CBRE, gross yields on ground rents, where payments increase in line with RPI every five years, have fallen from 3.8 per cent to 3.2 per cent. As yields have fallen across the asset class so has their potential future attractiveness in a period of higher interest rates. We don’t expect interest rates to rise sharply over the medium term but it is not unreasonable to expect that demand for ground rents will fall as some investors return to traditional, safe-haven income sources, such as Gilts.

The value of a freehold with a long-dated lease of perhaps 150 years is very low but increases over time as we approach the point where the freehold owner can be released. This is known as reversion i.e. the property reverts from the leaseholder to the freeholder. Amassing a portfolio of ground rents with reversion strategy is probably too long term for most investors (and their grandchildren) but it adds an interesting dynamic.

Overall, given the strength of the UK equity market since the last major correction in 2011, alternative investments such as ground rents can provide diversification within portfolios and also potentially attractive and inflation-protected income streams.

Key takeaway:

While property valuations are high in this low interest rate world, ground rents may offer a cheaper alternative. But it’s a niche asset class with few funds on offer.

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